U.S. defense spending bonanza puts niche acquisitions in play

WASHINGTON (Reuters) – Rising U.S. government spending on the Pentagon is fueling a spree of deal making among defense companies.

The U.S. Republican party’s willingness to boost the Pentagon’s budget to nearly $700 billion last year, helped by December’s corporate tax cuts, is also pushing up valuations for even lesser known companies in the sector and making sellers more willing to entertain overtures.

On Monday, the same day that U.S. President Donald Trump presented his second annual federal budget proposal, weapons maker General Dynamics Corp. (GD.N) said it was buying CSRA Inc (CSRA.N) to expand its government services business.

“We have an increasing budget going forward, that gives us cause for optimism that the services market is going to come back to pre-2011 characteristics,” General Dynamics executive vice president of Information Systems Technology Daniel Johnson told Wall Street analysts after the $6.8 billion deal was announced.

The cut in the U.S. corporate tax rate approved in late 2017, from 35 percent to 21 percent, has also made buyers more willing to spend a little extra.

“Executives see the budgets coming out of the Pentagon and see that it’s not a short-term fix,” said Bill Farmer, head of aerospace and defense investment banking at Teneo Capital, adding “you’ve also got the tax cut creating a lot of money.”

The net effect is a hot merger market where a broader group of weapons makers and government service providers are seen as attractive.

Companies involved in deals include U.S. military security services business Constellis, formerly known as Blackwater when it was founded in 1997 by former U.S. Navy SEAL officer Erik Prince. The company changed its name to Xe Services LLC in 2009 after a deadly 2007 shootout in Iraq tarnished its brand.

Apollo Global Management LLC, the New York-based private equity firm, purchased Constellis for about $1 billion in August 2016, but underscoring the strength of the current market, the sale of Constellis could fetch around $2.5 billion after less than two years.

The sale process for Constellis attracted industry participants such as Garda World Security Corp, Allied Universal Security Services, and G4S PLC (GFS.L) as well as private equity firms, people familiar with the deal said on condition of anonymity.

Constellis took initial bids last week, one of the people said, without elaborating on which companies ultimately bid. Apollo declined to comment.

Another example of a company with niche products attracting more robust values involved the recent sale of EaglePicher Technologies, LLC which makes the batteries used to power precision guided munitions like Paveway missiles and JDAM guidance kits that convert “dumb bombs” into “smart” munitions.

EaglePicher was sold to private equity firm GTCR for about $930 million or more than 11.5 times its estimated annual earnings of about $80 million, a strong valuation for such a niche player.

Part of the rich valuation comes from demand for precision guided munitions in several conflicts. Trump’s 2019 budget request seeks more than $10 billion in funding for tactical missiles. Saudi Arabia recently agreed to buy about $7 billion worth of precision guided munitions from U.S. weapons makers.

While some companies and private equity firms are looking to gain exposure to the defense spending trend, others are using the active acquisition market to unload their less profitable businesses.

L3 Technologies Inc (LLL.N) said in December it would sell Vertex, its aerospace and defense logistics support services unit. L3, under recently installed CEO Chris Kubasik, would rather focus on building its intelligence, surveillance and reconnaissance, and communication systems businesses which it believes will be more profitable in the future.